Mid-Caps: Make Hay While They Shine

The performance of Mid-Cap stocks over the past decade shows that they make for a good investment choice in a rising market, moving in step with and sometimes even outperforming the broader indices. Invest in mid-cap stocks to add a zing to your portfolio, Shashikant advises.

After a lull of almost more than 15 months, the equity markets have been looking up over the past three months thanks to a slew of reforms that the government has undertaken. This is reflected in the performance of the Sensex, which is the barometer of the health of stock markets in India. This is up eight per cent from the middle of September 2012, when the reforms were initiated.

The BSE Mid-Cap index has gone up by 13 per cent over the same period. Past experience suggests that this is the most opportune time for investors to shrug off their risk averse nature and take some calculated risks. The best way to start this is to diversify into well-managed mid-cap stocks.

During the period between 2003 and the beginning of 2008 (until the subprime crisis struck), mid-cap stocks emerged as clear winners and have outperformed the broader markets. During this period, the BSE Sensex was up by 5.8x, whereas the BSE Mid Cap Index outperformed the Sensex by a huge margin, going up by 9.2x. However, the following year spelt disaster for mid-cap stocks as they tanked faster and deeper than their large-cap counterparts. From January 2008 (from the peak) till March 2009 (when market touched its lowest point), the BSE Mid- Cap Index lost almost 62 per cent of its value, whereas the Sensex was down 45 per cent. 

This pattern was visible again when the market started its upward journey from March 2009 until December 2010, and its fall again through to the year 2011. What we really are trying to point out is the volatile nature of mid-cap stocks, which are more vulnerable to market fluctuations.

Does this discussion suggest that investors should ignore this segment of the market and remain invested in large-caps? Surely not. Though mid-cap stocks are more volatile and susceptible to large swings in a shorter duration, we believe that by investing in quality mid-caps with good managements, one can avoid the pitfalls to a large extent and reap the benefits of investing in this segment. Moreover, mid-cap companies are typically future leaders, and hence, one should invest in these stocks with a long-term horizon.[PAGE BREAK]

In fact, the composition of the BSE Mid-Cap index is very dynamic. Sometimes, companies that are part of the mid-cap set graduate to becoming large-caps and are no longer susceptible to the wide fluctuations experienced by the mid-cap counters. The reason for this is that such mid-cap companies are in the sweet spot of their life cycle. They have worked their way through their initial development phase, and are in a position where they can look at graduating to the large-cap space.

Although timing the market is an art that no one has mastered yet, we still maintain that this is the right time to invest in mid-cap stocks. This has been exemplified by the numbers we provided above. Mid-caps tend to outperform the broader market at times like the current ones. According to the criteria we have used (companies with market capitalisation between Rs 500 crore to Rs 3000 crore), there are a little more than 400 stocks that fit into the mid-cap space. They cover an entire gamut of sectors, from Power to Pharmaceuticals and from BFSI to Auto.

To help our readers, we are recommending five stocks that, we believe, one should hold with a longer perspective to reap the benefits of investing in them. Depending on an individual’s risk profile, one may consider an exposure of between 20-25 per cent of the entire portfolio value to these mid-cap stocks.

METHODOLOGY: It is always a good idea to substantiate what you do. We, at DSIJ, have always shared with our readers the methods that we employ to select the best stocks for them. Keeping with our tradition of transparency in our selection criteria, here is how we got to the list of the stocks recommended above.

• To start with, we took the entire universe of mid-cap stocks (market capitalisation between Rs 500 crore to Rs 3000 crore).
• The first filter that we applied was the quarterly numbers for Q2FY13, where we selected only those companies which have seen their topline and bottomline growing on a sequential as well as yearly basis. This gave us approximately 90 companies.
• We than checked the fi nancials of each of these 90 companies, mainly looking for any extraordinary items, margin
• improvements and other factors that make up for a strong balance sheet.
• Having done that, we finally selected these companies by looking at qualitative factors such as corporate governance and the pledging of shares by promoters.[PAGE BREAK]

Ajanta Pharma

After grounding itself firmly in the ophthalmology, dermatology and cardiac segments, Ajanta Pharma has marked its entry into other areas including ENT, gastroenterology and orthopaedics. The strategy seems to be a good one, especially considering the revenue growth that the company has clocked after this move. The topline and the bottomline of the company have witnessed a three-year CAGR of 24.40 per cent and 44.82 per cent respectively.

Ajanta’s is an interesting case, as it is a mid-cap company in the high-margin domestic formulations business. Although it is a late entrant and despite some stiff competition because of the generic nature of the market, the company not only has managed to penetrate the market but has also created an entry barrier by building brands and improved its ranking.

The market in the key categories where it operates is growing at about 20 per cent, which is well above the average industry growth rate. Ajanta has selectively focussed on the ophthalmology, cardiac and dermatology sub-segments instead of going all out to launch products in various sub-segments. This strategy has helped the company to maintain its growth momentum, gain a decent market share in the therapeutic sub-segments and hold on to its profit margins.

On the exports front too, it has been gaining strength. Ajanta initially began by establishing a foothold in Asia, Africa and Latin America. Its formulations plant has been approved by authorities in these countries. It has received approvals for its plant from the USFDA and the UK MHRA. To begin with, for these markets it has in placed an approval for two ANDAs and seven of them are pending. The company plans to enter the US market in H2FY13 with the launch of Risperidone. Over the next few years, it plans to step up its filings in these regulated markets. It is also setting up another plant to cater to the growing demand from these regulated markets.

On the financial front, it reported a strong performance for H1FY13 where the topline and the bottomline grew by 37 per cent and 70 per cent respectively on a YoY basis. On the valuations front, the stock discounts its trailing 12-month earnings by 11.10x. This looks cheaper as compared to other listed players in the formulations space. One point that particularly needs to be mentioned is that the company has been reducing its debt over the last three years. It has brought its debt-to-equity ratio down from 1.23x in FY10 to 0.69 in FY12. We remain bullish on the counter and recommend that investors buy the stock with a long-term perspective.[PAGE BREAK]

Astral Poly Technik

After looking at how home décor preferences have changed, causing some companies to flourish, here is one company from a slightly different segment. Astral Poly Technik (APTL), is a Gujarat-based manufacturer of chlorinated polyvinyl chloride (CPVC) plumbing systems for both residential and industrial applications, and also manufactures lead-free polyvinyl chloride pipes (PVC). CPVC contributes to about 65 per cent of its total revenues and the remaining 35 per cent comes from lead-free PVC. Over time, backed by a strong network of 10000 dealers and 300 distributers, ATPL has emerged as a market leader (enjoying 60 per cent market share) in the Rs 600 crore domestic CPVC pipes and fittings market.

ATPL has production facilities in Gujarat and Himachal Pradesh, which are capable of producing both pipes as well as fi ttings. The company has also spread its wings into the emerging markets of Africa, Bangladesh, Sri Lanka and Nepal by exporting its products there. With a view of catering to the increasing demand of CPVC/PVC pipes in Africa, coupled with the intention of reducing its import duty burden and logistics cost, ATPL has set up a manufacturing facility at Nairobi with an installed capacity of 6000 TPA. It has a tie-up with Specialty Process LLC of USA to incorporate the latest technology and globally accepted quality control programmes and also to develop CPVC plumbing systems as per the demands of the Indian plumbing market.

On the financial front, for the five years ending FY12, APTL’s topline has witnessed a CAGR of 44 per cent, while the bottomline has increased by 24 per cent during the same time. The company continued with this good performance for the first half of FY13, and its total income increased by 49 per cent and the profit went up by 25 per cent on yearly basis. It is expected to continue with its growth momentum, with a strong demand for plumbing systems from the replacement market as well as the new market. Its increased product range enables APTL to act as a one-stop solutions provider for a range of plumbing requirements.

At its CMP, the stock trades at 19x of its last 12-months trailing EPS. Although the valuations are on the higher side, which may limit any signifi cant outperformance of the stock in the short term, mid-cap stocks do yield superior returns over the medium-to-longer term. One should take exposure to this counter at the current prices.[PAGE BREAK]

Balkrishna Industries

Balkrishna Industries (BIL) is a niche play on the off highway tyres (OHT) segment. It mainly caters to the tyre requirements for material handling equipment, construction equipment, earth-moving equipment and farm equipment. In this, BIL commands a 3.5 per cent of the global market share. It has a strong product portfolio of 1900 stock keeping units (SKUs) coupled with a strong distribution network, and operates at a low labour cost, which gives the company a distinctive advantage over its competitors.

BIL derives 80 per cent of its revenue from the replacement market, wherein it sells to the distribution network, thereby saving on inventory carrying and other related costs. This ensures superior margins (the replacement market has a three-five per cent higher margin than selling to original equipment manufacturers) and lends stability in turbulent times. The company has a strong global network consisting of 200 distributors catering to the replacement market across 120 countries.

One major area where the company saves its resources is on the labour cost front. Compared to the labour cost at around 20 per cent of revenues internationally, BIL spends just around three per cent of its revenue on labour. This factor helps the company to offer its products cheaper by almost 25 per cent as compared to its competitors.

The other factor that is likely to benefit the company going forward is the decline in rubber prices in India. The domestic price of rubber, which traditionally remains above the international prices, touched a low of Rs 160 per kg, down by nearly Rs 5 from the international level. This will help the company to boost its margins.

BIL already enjoys a margin of 20 per cent at operating level and around 10 per cent at the net level. Against this, international players have margins of below 11 per cent and at five per cent at the operating and net levels respectively. Over the last five years, its topline has seen a CAGR of 28 per cent and the bottomline has grown at 25 per cent. We believe that BIL will continue to grow at the same pace going forward, as it has undertaken capacity expansion, wherein it will add to the extent of around 90 per cent of its existing capacity. With this significant capex plan, BIL expects to gain a significant market share in the global OHT space.

At the current market price of Rs 270, the shares of BIL discount the company’s last 12-months’ earnings by just 7.5x. Looking at its aggressive growth plans, its superior margins and the attractive valuations at which the counter is available, we advise readers to make this counter a part of their mid-cap portfolio.[PAGE BREAK]

Kajaria Ceramics

When was the last time you refurbished your house? To be more specific, how much of thought did you put into the type of finishing that you would want your dream home to have? Changing demographics have lead to a sea change in this key thought process of the Indian consumer, and this is where companies like the Delhi-based Kajaria Ceramics (KCL) have been thriving.

KCL is India’s second largest tile manufacturer with about nine per cent of the overall tiles market and about 18.5 per cent of the organised market. The demand for its products and its standing in the market has been very good. This is reflecting well in the growth it has seen. Over the last few years, its revenue growth is consistently beating that of the overall market. In the last four years, its revenues have seen a CAGR of 27 per cent and its net profit has grown by 52 per cent. The net profit of this company has also registered a five-fold growth over the last five years. Such growth has come in despite a slowdown in the overall real estate market. In fact, the demand for its products comes not only from new homes but it also caters to a big replacement market.

The company is mainly into manufacturing, marketing and selling ceramic/vitrified tiles, and it has a total annual capacity of manufacturing 41 million square meters (MSM) of tiles. It has six plants located in different parts of the country and has also added capacity inorganically, with a total of four acquisitions in the last one year. After these acquisitions, the company has managed to expand some of these capacities at a lower cost than greenfi eld investment requirements would have called for. It has recently started the production of digital ceramic tiles from its Vijayawada facility. The recent acquisition at Morbi, Gujarat gave it access to 2.6 MSM of vitrified tile manufacturing facility and will prove to be very positive for this stock. Its total capacity has increased from 36 MSM to 41 MSM in just six months’ time. Hence, we believe that growth for this company will be even better in the second half of the year.

All these positives are already reflected in the stock price of KCL, which is up by more than 2.5x on a year-till-date basis. However, looking at the past growth rate of the company and an attractive growth rate going forward, driven primarily by the strong brand value and growing aspirations of domestic consumers, we believe that the company will maintain its growth momentum. The stock is currently trading at a PE multiple of 19x its trailing 12-month EPS of Rs 12.68. This looks attractive as the PE-to-Growth (EPS of the last five years) ratio comes out to be below 0.5. Therefore, we advise readers to take exposure to the counter at the current market price.[PAGE BREAK]

Zydus Wellness

Sugar Free, EverYuth and Nutralite are brands that most of us are aware of. Over a period of time, these brands have been able to establish themselves strongly in consumers’ minds. With its focus on the consumer wellness segment, the owner of these brands, Zydus Wellness, has been able to find a strong base, which is witnessed by the market share that its products enjoy.

A look at the balance sheet of the company tells you that the greatest highlight of its financial strength is that it is a virtually debt-free company, with a liability of merely Rs 1.55 crore on its books. It has a strong field force of more than 500 persons, which reaches out to all towns with a population of more than 50000.

According to global marketing research firm A C Nielsen, Sugar Free has a market share of 90 per cent in the sugar substitute market as of FY12. With the increasing health consciousness among the Indian population, this product is likely to witness better growth going forward. Another of its brands, EverYuth has also maintained its leadership position in categories like peel-offs, face wash and scrubs. However, this category continues to face stiff competition from other leading players in this segment. Nutralite too has established itself well despite launches from competitors in low cost versions. The company has forayed into the nutraceuticals space with the launch of ActiLife, a nutritional milk additive for adults.

Going forward, these brands are likely to rake in better revenues for the company. The company has been scouting for long-term growth opportunities with new products. It is also looking forward to introduce or acquire related or innovative products that will be value accretive going forward. It is also putting in efforts to expand its reach and look at untapped opportunities. On the financial front, the company has performed well in H1FY13. The topline and the bottomline grew by 6.37 per cent and 45.24 per cent respectively on a YoY basis for the same period. On the valuations front, the stock discounts its trailing 12-month earnings by 24.32x. The prospects of this stock look fairly bright to us.